27 February 2013 External T.I. 2013-0477601E5 - Interest Deductibility on Restructured Borrowings

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether interest would be deductible where borrowings are restructured.

Position: A question of fact. Generally yes provided that there is a direct link between the borrowed funds and an eligible use.

Reasons: Previous positions and court cases.

XXXXXXXXXX
2013-047760
Andrea Boyle, CGA

February 27, 2013

Dear XXXXXXXXXX:

Re: Interest Deductibility

We are writing in reply to your correspondence received February 6, 2013. You asked us whether, under certain circumstances, interest would be deductible where borrowed money is used to purchase publicly-traded common shares. Specifically, you asked whether interest on a loan would be deductible for income tax purposes where:

• An individual uses the proceeds from the sale of publicly-traded common shares to pay down a mortgage on a personal residence.
• The individual then takes out a loan and uses the proceeds from that loan to repurchase identical shares in that same publicly-traded corporation.

Specific provisions of the Income Tax Act must be met in order for interest to be deductible. These provisions include the requirement that an amount be paid in the year or payable in respect of the year, that the amount be paid pursuant to a legal obligation, and that the amount be reasonable. Where money is borrowed, the use of the money must be established and the purpose of that current use of the borrowed money must be for earning income. Where an amount is payable for property acquired, the property must be acquired for the purpose of earning income.

In your correspondence, you have referred to two Supreme Court of Canada cases, The Queen v Singleton 2001 SCC 61 and Lipson et al v The Queen 2009 SCC 1, and you have asked us for clarification as to why in the Singleton case the interest deduction was "allowed" whereas in the Lipson case the deduction was "not allowed".

In The Queen v Singleton, the taxpayer withdrew equity from his law firm to purchase a house. He then refinanced his law firm equity with borrowed money. The taxpayer paid interest on the borrowed money which he deducted on his tax return under subparagraph 20(1)(c)(i) of the Income Tax Act. In Singleton, the Court found:

In this case, a direct link can be drawn between the borrowed money and an eligible use, so the respondent was entitled to deduct from his income the relevant interest payments…

In the second case, Lipson et al v The Queen, the taxpayer (Mr. Lipson) also attempted to restructure his financial affairs in order to obtain an interest deduction in respect of borrowed funds which were used indirectly to purchase a personal residence. In this case, Mrs. Lipson borrowed money from the bank and used the funds to purchase shares in a family corporation from Mr. Lipson. Mr. Lipson used the money from the share sale to pay most of the purchase price of a new family home. Mr. and Mrs. Lipson then jointly obtained a mortgage from the bank and used the funds to repay Mrs. Lipson's original loan in its entirety. The "income attribution rules" applied to attribute the net income or loss (dividend income less interest expense) arising on the family corporation shares held by Mrs. Lipson back to Mr. Lipson. Mr. Lipson sought to deduct the interest on the basis that it was interest on borrowed money used to repay a loan made for an eligible purpose.

In the Lipson case, the Court ruled that the general anti-avoidance rule (GAAR) should apply because the transactions resulted in an abuse of the attribution rules of the income tax legislation. The Court did not find the refinancing aspect of the transaction offensive. Specifically, in Lipson, the Court said:

…The Minister concedes that, were it not for the GAAR, Mr. Lipson could properly deduct the interest expense under s. 20(1)(c)... If, as in Singleton, the issue in the instant case were whether the deduction was properly available under s. 20(1)(c), the Minister's concession would be fatal.

Generally, the GAAR applies when a transaction results, directly or indirectly, in a misuse or abuse of the provisions of the Income Tax Act read as a whole. The purpose of subsection 74.1(1) of the Income Tax Act is to prevent spouses from reducing tax by taking advantage of their non-arm's length relationship when transferring property between themselves. In Lipson the court found that:

The only way the Lipsons could have produced the result in this case was by taking advantage of their non-arm's length relationship. Therefore, the attribution by operation of s. 74.1(1) that allowed Mr. Lipson to deduct the interest in order to reduce the tax payable on the dividend income from the shares and other income, which he would not have been able to do were Mrs. Lipson dealing with him at arm's length, qualifies as abusive tax avoidance...

In other words, the Court did not change its conclusion from that in Singleton; in Lipson the Court still made it clear that, providing that the provisions of the Income Tax Act are appropriately adhered to, a taxpayer can generally arrange or rearrange his or her affairs so as to be entitled to deduct interest on debt.

For further information which addresses the question which you have asked, you may wish to consult the Canada Revenue Agency (CRA) Interpretation Bulletin IT-533 Interest Deductibility and Related Issues which is available on the CRA website at http://www.cra-arc.gc.ca/E/pub/tp/it533/README.html.

We trust that these comments will be of assistance.

Yours truly,

Doug Watson
for Director
Corporate Financing Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch